Have copied an article which somebody forwarded to me on mail. I honestly don’t know if I am violating any copyright norms by doing this, but in case I am, my humble apologies for the same –
Make Money With Ice Cream
TODAY I’M GOING TO TALK ABOUT ICE CREAM.
That’s right – ice cream.
Why? Because understanding basic business in America is as easy as understanding ice cream. And since I’m lactose intolerant (not to mention a bit hefty in the waistline), this gives me a guilt-free way to discuss my favorite subject. In addition, understanding business is the key to understanding stocks. And that’s what we’re all here for, ladies and gentlemen, isn’t it?
Great … so sit back and relax as we play a quick game of Tycoon Monopoly.
Are you ready?
OK. Now let’s assume that you lived down here in Delray Beach, Florida.(Yes, for the sake of this discussion, just assume you’re cool with the fact that it’s a cultural vacuum, OK?) But the weather is always hot, and people are always thinking about refreshments. One day, your friend Jason comes to you and asks you to invest in a new ice cream parlor he wants to open.
After doing your research, you realize – quite surprisingly – that there isn’t one single ice cream parlor on the entire beach. You seize the opportunity and invest. Within three months, “Jason’s Ice Cream Parlor” is officially open.
Six months later, “Jason’s” is doing more business than you ever dreamed. Good press. Lines around the block. Heck, a camera crew from Page Six picks up a Britney temper tantrum outside! But that’s not the best part.
The best part is that because you have the only ice cream shop in town, you guys are able to charge everybody very high prices for the ice cream. In fact, each cone sells for $10 instead of the $5 they sell for in the neighboring town! From a business perspective, that’s great news indeed.
Why? Because you invested $10,000 to start the business. And since you’re able to sell each cone for $10, you realize that you’ll wind up making $3,000 in profits at the end of the year! A 30 percent annual return on the capital you invested to start the business – not bad at all!
But then one day – as you’re being driven around Delray Beach in your brand new Rolls Royce – you realize that another ice cream shop opened up down the block. Yes, Bob’s Ice Cream Shop just announced its grand opening. At first, you get concerned…you debate whether it’s time to take out the ol’ Brooklyn firebomb kit stored away in the garage. (You can take the kid out of NYC, but you can’t take NYC out of the kid!) But you decide against it … still plenty of business to go around, you think to yourself.
But your prices have dropped a bit in the face of stiff competition from Bob. Indeed, instead of $10 per cone, you’re now selling them for $7.50. But it doesn’t stop there. Suddenly realizing how much money there is in ice cream, five more shops open on the beach.
That’s one ice cream shop for each square mile! Pretty soon, the competition becomes so fierce that prices drop rapidly. Now, instead of selling ice cream for $10 per cone or $7.50 per cone, you’re lucky to get $5 per cone. That means that your profits have dropped by half – from $3,000 to $1,500 per year! That’s only a 15% annual return on the capital you’ve invested ($10,000)!
It’s at this point that you learn several important lessons about investing:
Lesson # 1. Strong businesses attract competition.
Lesson # 2. Competition lowers prices.
Lesson # 3. Lower prices mean lower returns on capital.
As you begin to digest these lessons, Jason comes to you with what seems like a good idea. The bank has offered him a $10 million line of credit to expand the business. You guys jump at the offer. With that kind of money you could open more stores and wipe out the competition. But during the 90 days it takes to close the loan, 10 more ice cream stores open on the beach. Prices drop from $5 a cone to $1.50 per cone.
Why? Because all these ice cream stores sell essentially the same product. And since they all need to pay for rents and salaries, they have to bring people into the stores. And nothing brings people into stores better than discounts. But now, the terrible price competition has eliminated your profit entirely. In other words, whatever pricing power you had is completely gone. You now have a commodity product – a product that competes solely on price . But that’s only half the problem.
The other half is even worse: now a recession hits. So here you are – an owner of a company that sells a commodity product with way too much debt – entering a recession. And now, for every cone you sell for $1.50, you lose 10 cents.
Why? Because the interest expense on the debt is beginning to choke you. It’s at this point that you learn your 4th valuable lesson about investing:
Lesson # 4. Never invest in a company that has a lot of debt.
ESPECIALLY A COMPANY THAT COMPETES IN AN INDUSTRY WITHOUT PRICING POWER.
Because at some point – and this is a guarantee – you will enter a recession.
And while a recession can be a terrible thing for some businesses, it can be great for others. Let me explain.
The recession was so severe that 12 out of the 17 ice cream shops on the beach quickly went out of business. That’s the good news. The bad news is that your ice cream shop was one of them. The bank called your loan. But our story doesn’t quite end there.
As you walk home from the auction that sold your beloved property, you realize something new: Bob’s Ice Cream Shop – the second shop to open after yours – didn’t take on any debt and kept its costs low. And right now, Bob is using all the money he has to buy out the remainder of his struggling competitors. That’s right. He’s consolidating the industry to eliminate the competition. He’s making sure that by the time the recession is officially over, Bob’s Ice Cream Shop is the dominant player on the beach.
Yup – 30 percent returns on capital will soon be Bob’s for the taking – as long as he can survive the recession. And it’s right then and there that you learn your next lesson:
Lesson #5: Companies that run lean, debt-free operations during boom times, quickly become consolidators and gain market share during bust times.
Airlines, automobiles, internet, software, hardware, insurance, railroads, radio …It’s the nature of business, and it’s happened since the beginning of time. And it’s exactly what’s happening now to you.